The corporate sector and the economy

Profits of doom

ONE of the striking divergences in the US economy is how well the corporate sector has performed relative to the consumer. This is one reason why the stockmarket was doing so well (until this summer) and why valuations based on recent earnings make the market look a lot cheaper than those based on the Shiller p/e.

Andrew Smithers has drawn attention to this in his latest report. He is a feisty economist best known for his work on the Q ratio (referred to in the above link) and happy to take on most strategists at investment banks, who he regards as mere salesmen for equities. He notes that

US profit margins have risen sharply despite the weakness of the economy. It should be noted that this is an unusual response to cyclical weakness in the economy and cannot therefore be explained away by assuming that it is caused by secular changes, such as a change in the bargaining power of labour. In addition, it should be noted that if such claims had any validity, any downward pressure on wages per person would be accompanied by a tendency to substitute labour for capital in terms of numbers employed. It has been widely remarked that the opposite has been the case, with unemployment rising particularly sharply during this period of economic weakness.

The explanation, in Smithers' view, lies in the role played by incentives in manager remuneration.

There has been a marked increase in the proportion of total pay coming from bonuses or options rather than salaries. This has led to companies' managements being primarily concerned with short-term changes in share price, earnings per share or return on equity.

Indeed, this may explain why profit margins have been more robust than elsewhere since US managers are most incentivised. Shareholder value has not worked well for employees.

Now Smithers wants margins to fall. Why? His argument is that fiscal deficits need to come down. This must be matched by a decline in the cashflows of the other sectors; the household sector is too weak to cope so the corporate sector is the one that must adjust.

Since it is unlikely that incentives will change, profit margins can only come through lower prices. This will necessitate a long period of weak demand but will have positive side-effects. First, it will give real wages a boost. Second, low inflation in the west, combined with falling real exchange rates, will make it easier for the global current account adjustment to occur. The alternative would be for emerging markets to allow high inflation of real exchange rate appreciation, but they are resisting both.

All this leads him to the conclusion that further fiscal and monetary stimulus would both be mistaken since they would retard the necessary adjustment in current accounts. And he adds that

Falls in asset prices drive up savings and push down investment and their impact is amplified by high levels of debt. Asset prices are more likely to fall sharply the higher they are above their equilibrium levels. It is therefore important to avoid policies which drive up asset prices and this is particularly important when debt levels are very high. Policies which are either designed to raise asset prices or have this impact are therefore undesirable. Central banks should therefore avoid buying assets, which naturally pushes up their prices, particularly when asset prices are already very high, which is clearly the case today with US shares and UK houses.

Now, a lot of you may be unimpressed with this logic, and the obvious flaw is that he seems to start with the conclusion he eventually reaches; since he wants fiscal deficits to come down, he resists fiscal stimulus. Still, I think the points made about profits and management incentives are good and (confirmation bias alert) naturally I agree with the bit about propping up asset prices.

AtlantisKing wrote: "cut the government size back to what it was just before the crisis. Voilá! The deficit is manageable again and we didn't have to destroy the corporations on the process"

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While it may be convenient and even enjoyable by some to try to link the current American economic situation to the size and scope of the federal government, a direct causal relationship in this case is a little weak. Are companies concerned about the federal deficit and business-friendly legislation? Absolutely, but I think we're talking about two different issues here.

The core issue, which Andrew Smithers addresses and Buttonwood lends credence to, is that remuneration which relies primarily on incentives and bonuses leads to short-term gains at the long-term expense of the company, which ultimately leads back to the economy as a whole. Its the old issue of short-termism vs long-termism (http://blogs.hbr.org/leadinggreen/2008/10/redefining-global-capitalism-i...)

While a singular example lacks validity, I can at least share my current experience: The moderately large company that I work for has been gutted over the past few years by short-term thinking and gains from top-level management. Ironically, during the downturn my company has not seen volume or profit losses (though some transformations have occurred), they have actually seen real volume and profit increases since 2008. The stock price has also rise about 20% since 2009.

From an investment standpoint the company looks solid; year-on-year market growth, increased sales, increased profit margins, lowered operating-costs, increasing stock price, etc. However, the work environment that I see is one that is close to the breaking point. Wages have been frozen or reduced, benefits reduced, full-time employees are no longer hired - only part-timers to save costs, greater productivity is demanded without compensation, an so on. The environment is threatening and likely unstable.

While this current process became more pronounced during the downturn, it began in earnest before 2008. The company has hired a cycle of top management executives who have sought to affect all of those aspects that indicate performance - profit margins, operating cost, etc. While in theory such aspects are part of healthy business development, the cycle of managers have been primarily focused on short-term gains for two reasons. First, they are incentized to do so by their compensation arrangement, and second, they are looking toward their next position. After spending 2-3 years at one company, they will move on, hoping to repeat the same 'success' at another. They are replaced with another such individual who is also looking to define a 'positive' financial track record for themselves, though the real costs are typically overlooked or ignored completely.

The cycle of such managers has absolutely destroyed the heart and soul of my company. There are already serious cracks in the foundation of my organization at the moment, and I would expect that if the short-termism mantra is not modified within the next two years that the company will start to obliterate itself.

The knock-on effects of similar companies to the economy is what Buttonwood and Smithers appear to indicate as 'profits of doom'. This situation appears to be the direct and indirect result of compensation policies, career progression processes, the growing divide between management and employee, and good old-fashioned greed. In a sense its bringing the temple down on our heads.

Singular example yes, so take it for what its worth, comments and substantive criticism welcome.

Here is another example of ivory tower thinking.
Lack of demand in the middle class is the problem.
Businesses have been so successful in creating human resource constipation; trimming back on all expenses on employees,
that they have destroyed demand in the market.
Profitsharing is the answer.
We are told government cannot create "real" jobs.
So let the private sector re-invest in itself.
Share up to 20% of net profits with employees before stockholders dividends are calculated. Perhaps a profitsharing tax credit will incentivize such a plan at the national level. And perhaps a healthy tax should be imposed if businesses do not participate.
Private industry recieves BILLIONS in government subsidies.
It is time to reinvest in helping to increase demand.
It would be good for business, good for the nation, good for the world.

"It is therefore important to avoid policies which drive up asset prices and this is particularly important when debt levels are very high. Policies which are either designed to raise asset prices or have this impact are therefore undesirable."

I'm sorry, but this sentence makes absolutely no sense. I agree that artificial price inflation is least desirable, but the idea that falling asset prices is ideal in a time of high debt load is ludicrous. That's like saying that all those bank writedowns in 2008-2009 were good for shareholders.

Smithers says "Falls in asset prices drive up savings and push down investment...." It appears that he is assuming that "savings" are sitting in a bank account or something. it reality, a significant amount of "savings" is actually invested, either in mutual funds or stocks. And falling asset prices means that the nominal value of those investments is going to decline as well.

The only way to avoid that is to sell investments and put the money into a bank account. Is that really what Mr. Smithers thinks would be good for the economy?

AtlantisKing wrote: "cut the government size back to what it was just before the crisis. Voilá! The deficit is manageable again and we didn't have to destroy the corporations on the process"
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If the size of government was reduced and the deficit brought down to manageable levels....I would immediately sell my gold...withdraw my cash...and engage in new economic activity. I believe there are trillions and trillions of dollars setting on the sidelines just waiting for a president and a congress that will take credible action to balance the budget and reduce the size of government spending. But for now...we're just waiting for the government debt induced economic crash that is sure to come.

I think Falls is explaining finance/economics the same way my 2nd or 3rd ex-wife did.

"This (whatever she bought) was on sale for $100, so "we" saved $50."
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ShaunP,

Falling asset prices only hurt when one still owes money or is leveraged on the asset. If you own your house outright and plan to live there for another 10 - 20 years and are not planning on borrowing against it, does it matter if the "price" falls for 3-5 years?

Another take...
Suppose I own a house outright and its value is $100k. If I want to buy a $200k house, then I need to borrow $100k.

If the values drop 20%, then I need $80k to get from $80k to $160k.
But one must hope wages don't drop.
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AtlantisKing,
We could start cuts with all of the subsidies to farmers, businesses, etc.

"This has led to companies' managements being primarily concerned with short-term changes in share price, earnings per share or return on equity"
Hedge fund Guy's observation the other day on the popularity of share buy backs seem to underscore the above. After all why do the hard work of making a product and selling it when you can pump your stock options value instead.

Under which rock did you find this guy? His reasoning is so full of holes that it almost takes the fun out of making fun of him...

Rathsr than going for a point by point discussion here, I'll concentrate ona single issue. Strong corporate profit are a consequence of higher productivity, growing emerging markets operations (for multinationals) and, yes, focused management. Which one of those does this genius think will have to drop because "fiscal deficits need to come down"?

Let me offer an alternative suggestion: cut the government size back to what it was just before the crisis. Voilá! The deficit is manageable again and we didn't have to destroy the corporations on the process...

If profits are up in a depressed economy, the implication is surely that there is a market failure. Pressures on prices should result from all those improvements in productivity, etc. Why has this not happened? I don't get it.

According to an AP article:
Household wealth dropped by 0.3% in Q2 vs. Q1, 2011.
Corporations have over $2 Trillion in cash, up 4.5% from Q1.

Meanwhile...

Small business owners are getting more pessimistic
Joyce M. Rosenberg
Friday September 16, 2011

NEW YORK (AP) -- When the country recovered from recessions in the past, small businesses were usually the first companies to start hiring. But smaller companies are so pessimistic now that they're not taking on their historical leadership position.

The National Federation of Independent Business, which issues a monthly report on small business optimism, says "confidence in the future of the economy crashed in August." The group's optimism index -- which it wryly called the Small Business Pessimism index -- was down for the sixth straight month.

Thirty-four percent of owners surveyed said they expect their sales to fall in the next three months. Twenty-one percent expected sales to rise and 45 percent expected them to be unchanged.

The NFIB said 11 percent of the owners it surveyed in August planned to create jobs in the next three months. Twelve percent plan to cut jobs, and 77 plan no changes.

Dunkelberg says consumers, who ultimately drive sales, have lost their confidence in the government as well. He noted that nine out of 10 people have jobs -- but they're saving rather money than spending it because they're worried about the future.

"If Washington did something that made those nine out of 10 confident, they'd spend more," he said, and noted that "it's not just the economy, it's government" that worries people.

Business owners also appear to be lacking in confidence in the government. According to the NFIB survey, only 7 percent of owners expect business conditions to be better six months from now. Forty-one percent expect them to be worse, and 52 percent expect them to be unchanged.
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Small business needs sales, not tax cuts.

Time again to send out the helicopters Ben.
This time, send them over residential areas, not Wall Street.

Your right that there is a whole lot of money intentionally locked away. You're also right that congress is pretty darned incompetent, although, since we don't have a prime minister, I hesitate to extend full blame to the executive.

have you considered the possibility that storing all your wealth in gold and offshore accounts might be contributing to the problem?

Much of domestic S&P profit is from the financial sector, which is little more than redistribution to the financial sector via the bank levied printing tax, and other bailouts. This lowers the median standard of living, while increasing inequality (financial sector bonuses go up).

The free market should set asset prices. Manipulating prices either up or down interferes with efficient capital allocation.

Andrew is correct that lower CPI prices is the way to go. This would increase real wages, pensions, etc... The standard of living would go up, and consumers have a history of responding favorably to sale prices. Lower prices make people go shopping. Lower prices for tech gadgets have led to robust sales, while lofty prices for McMansions have stagnated sales. Consumers want a good deal. Consumers are only willing to trade so many hours on the job for an item. People will buy homes when they are once again good deal.

@jouris
While you are technically correct I think there is a difference between deposits in savings accounts and purchases of government savings bonds and investments. In many countries banks are limited in what they can do with the money invested in savings accounts and, hence, the paltry interest rates they can offer. Nevertheless, if equities look risky, people may still plump for the relative safety of negative real interest rates.

It seems to me that Smithers is referring to a phenomenon, the relative increase in returns on capital versus those on labour, that needs talking about.

Arguably many/most of the modern profit increases are rents created by information asymmetry (as in investment banking), bogus IP claims (the 75 year copyright claim for instance) or other government intervention on behalf of capital.

If the US were willing to tax these gains at a thumping great rate they could make some contribution to deficit reduction at no cost in economic efficiency. As it happens US rent collectors get the best of all worlds: lots of rent without effort and bugger all tax.

Your right that there is a whole lot of money intentionally locked away. You're also right that congress is pretty darned incompetent, although, since we don't have a prime minister, I hesitate to extend full blame to the executive.

have you considered the possibility that storing all your wealth in gold and offshore accounts might be contributing to the problem?

@Gordon L, why do you think we should tax capital gains at "a thumping great rate"? Don't you think it would be sufficient to simply charge them at the same rate as other income? (Rather than, as now, a substantially lower rate.)